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A McDonald's hamburger and fries on a table near City Hall October 13, 2010 in New York. (Image credit: AFP/Getty Images via @daylife)

Those of you who are newer to options, may be considering a strategy known as the Covered Call. This is a fairly straightforward strategy and can be executed in a few different ways, but for this particular piece we will focus on a one-price covered call (sometimes referred to as a “buy-write”) But before we get there, let’s define what it is we are talking about.

A Covered Call trade involves purchasing 100 shares of a stock, and selling (writing) 1 call against these shares. Please keep in mind that a standard options contract represents 100 shares of stock. In other words, you are buying stock and writing a call against it (buy-write). You can enter this all as one transaction if you would like so that you are filled with the stock and the call for one price and do not have to take price risk in getting one side and not the other.

This trade has uses in many strategies. One of the most common ways of thinking about it is to see it as a way to potentially enhance returns in your portfolio. Let’s take a look at a real-life example -- this is not a recommendation, in fact at this point the options have expired, but it illustrates our point well -- using McDonald's (MCD) stock from April 19, 2012.

Click to enlarge

On that day, as you can see in the graphic above, MCD stock was trading at $97.10 and the June 97.50 call was trading at $2.00. So to execute the covered call trade -- and this is the worst-case execution scenario of buying offer on stock and selling bid on call -- you could purchase the stock at $97.10 and simultaneously sell the call for $2.00 for a net cost on the trade of $95.10, or $9,510 for every 100 shares executed (plus transaction costs). Now, let’s take a look at the trade and some of the advantages and disadvantages to the trade.

In this trade, you are buying the stock and by selling the call you give another person the right to buy that stock from you at $97.50. It could be viewed as similar to purchasing a stock and immediately putting in a limit order to sell the stock for which you are being paid. The result it that you purchase the shares at $97.10, and sell the $97.50 for $2.00, which means you are going to sell that stock (have it called away) if it is above that strike price upon expiration. However, since you receive $2.00 in premium your effective selling price will be $99.50 rather than $97.50.

The best-case scenario from a return standpoint would be if the stock went to $97.49 on expiration and the option goes out worthless. However, the primary point from a risk management perspective is: am I comfortable selling the stock at the strike price plus the premium received?

Ultimately the problem most people have is they sell the call thinking of return. Instead, they should think of a comfortable level at which they are willing to have the stock called away -- essentially going into the trade willing to buy the stock at $97.10 and sell it at $97.50, plus $2 or an effective sale of $99.50 in 57 calendar days ( the number in parenthesis next to the month).

A common occurrence is that when the stock is rallying and near the strike price, investors will buy the call back in the hope that it continues to run. The risk is that you paid up to repurchase the call and the underlying stock turns around, which is why it is crucial to think about the level at which you are comfortable selling the stock when you first sell the call.

One warning for newer investors or those new to options and covered call strategies: beware those who say that selling calls provides "downside protection." The downside protection you get here is only for the amount of premium received. In our example you would be protected if McDonald's fell as low as $95.10. From that point on the risk is no different on the downside from being long naked stock.

So why would you ever make a trade that has limited upside and limited downside protection? The primary reason is that the probability of an option being out of the money on expiration day (Prob OTM in the graphic above) is 58% in this example. That is a nice probability of you keeping your premium. So you are making a trade that has potential to have a nice return while at the same time giving you limited downside protection (again very limited, but still a bit better than naked stock) and is very easy to trade and understand. So, as you arm your portfolio, you may want to consider, as Bruce Springsteen would say, “Cover Me.”

Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy. At TD Ameritrade the online commission costs would be $9.99, plus $0.75 per contract. Exercise or assignment fees would be $19.99.TD Ameritrade, Inc., member FINRA/SIPC/NFA